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posted on 25 April 2017

How Broken Is The Market?

by Pebblewriter, Pebblewriter.com

Yesterday, VIX experienced its 4th biggest drop ever, plunging 25.9% from Friday’s close even though France’s election delivered the very same results that just about everyone expected.

It has dropped even more this morning, and is now off 33.3% from Friday’s highs - despite the fact that there’s the potential for war on the Korean Peninsula and the probability of a government shutdown later this week.

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Is there any logic to this? What should we take away from the behaviour of the “Fear Index?"

Between 2014-2016, VIX very rarely tagged the bottom of a huge, rising channel (shown below in yellow.) When it did, this meant that fear was unusually low.

Click on any chart below for large image.

Without fail, however, every tag on the yellow channel bottom meant that stocks were at or very near a significant top.

Things changed, however, following the US election. VIX plunged right in the middle of stock futures’ 5.7% mini-crash. This was beyond ridiculous. Selling VIX as futures are plunging is the equivalent of cancelling your homeowners policy as a tornado is ripping the roof off your house.Who would do such a thing?

It would have to be someone with unbelievably deep pockets - someone for whom ensuring that stocks continued to march higher was more important than the many billions of dollars they might lose in the process. In other words - central banks.

In a note on Apr 21, Merrill Lynch reported that central banks have already “invested" over $1 trillion YTD - an amount on track to top 2008’s $2.8 trillion by 25% and more than double last year’s $1.7 trillion.

Some central banks, like the BoJ and SNB, invest directly in equities in order to manipulate stock prices higher. It’s more effective than big, clumsy measures like QE. Over the years, however, they’ve discovered they can get more bang for their buck by using more refined measures like the yen carry trade, oil futures and VIX to drive algorithms.

Simply put, algorithms look to a variety of indicators to tell them when to buy and sell stocks. If oil spikes higher, stocks will too. If USDJPY rallies, you can bet that stocks will be close on its heels. And, if VIX sheds 25% in a day, well…we’ve seen what happens, haven’t we?

Machine trading is gradually replacing real, live people - traders in pits who might look up, scratch their heads and ask “wait a second, does that make any sense!?" Just a few weeks ago BlackRock, the world’s largest investment manager with $5 trillion under management, announced it was laying off human traders and increasing its emphasis on machine trading.

When VIX drops, algos don’t ask why. They simply read it as a reduction in risk and trigger buy orders. However, as VIX approaches long-term support such as the huge, yellow channel, algos know that the rally is almost over. At least, that’s what they used to think.

In its last “normal" tag, on Aug 9, 2016, VIX correctly signaled a drop in ES that extended to 163 points at its election night lows. But, as mentioned above, VIX was hammered that night and, by mid-November, had broken down through channel support (the white arrow) in order to produce new all-time highs in stocks.

The next time VIX tagged the yellow channel line, on Dec 21, it produced a very modest 34-pt drop in ES. Were the algos learning? Was VIX signalling a fundamental change in the level of risk in the markets?Since Dec 21, VIX has dipped below the yellow channel bottom 27 times - an astounding one out of every four sessions. More importantly, the dips always come at crucial moments, when ES and SPX are in danger of breaking trend (thin purple lines below) or need a boost to get up over resistance.

The latest example, of course, is this week. ES and SPX have both been locked in a falling channel since their all-time highs on Mar 1. Yesterday, based largely on VIX’s historic plunge, futures broke out of that channel and are threatening to make new, all-time highs. Improbably, this has occurred during a week of highly elevated geopolitical and macroeconomic risks.

At 10.22 this morning, VIX almost reached the Feb 1 lows of 9.97 (the day it plunged 23% to convince algos that the Fed’s rate increase was no big deal.) The last time VIX was this low was in Feb 2007, just months before the S&P 500 peaked and crashed 58%. I’m not suggesting that a crash is imminent. But, I think it’s important to realize that the “market" is broken, and that its gains (e.g. the “Trump Rally“) possess all the integrity of a campaign promise.

There was a time when VIX was a great indicator of fear in the markets. Now, it’s just another tool with which to drive stocks higher. Put simply, the tail is wagging the dog. And, the people doing the tail-wagging are not only determined, they have access to an unlimited amount of free money.

Now, on to today’s forecast. SPX backtested to within 0.79 of our target at the yellow neckline yesterday before deciding that appearances aren’t all that important.

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